Behind The Sell-Off: Commercial Real Estate

Bonds and stocks with exposure to commercial real estate cratered on Wednesday on fears the fast-weakening U.S. economy could lead to a wave of defaults on loans for office buildings, retail stores and hotels.

Commercial mortgage-backed securities (CMBS) have been shattered this year amid expectations that weak underwriting standards and slowing economic growth will boost defaults from historically low rates.

Many loans in recent years were made on expectations that property values and cash flows from rents would continue to rise, leaving them the most vulnerable.

"There is a growing concern that (commercial real estate) is going to be another tripping point in the economy," adds William Larkin, portfolio manager with Cabot Money Management in Salem, Massachusetts. "No one wants to touch anything to do with real estate."

Selling accelerated last week after Treasury Secretary Henry Paulson said a $700 billion rescue plan would be geared toward providing banks with equity, rather than used as a fund to take illiquid mortgage assets -- such as CMBS -- off bank balance sheets. Commercial mortgage holdings contributed to the downfall of Lehman Brothers Holdings Inc. in September.

Taking The Hit

Big real estate companies were hardest hit in Wednesday with shares of Simon Property Group the No. 1 mall operator and Boston Properties , which owns skyscrapers and other office buildings taking the biggest hits.

"The mall operators are really, really in trouble," said Kevin Quinn, a managing director of equity trading at Stanford Group Company, mentioning Vornado Realty Trust as a key player. "There aren't even signs on the empty stores in the malls. They've been empty for a while, barren, tumbleweeds blowing through."

But the trouble isn't just with mall and office REITs. According to Karen Finerman the trouble also lies with, "heath care property investors such as HCP Inc. and banks such as BB&T which has huge commercial exposure."

"And keep an eye Phillips Electronics and Acuity Brands . Both make commercial light fixtures and may have more room on the downside," adds Guy Adami.

Outlooks on commercial properties are darkening as economic reports point to disappointing retail sales, amid rising unemployment and rising foreclosures. Forecasts for a mild recession are now "off the table," in favor of an average or severe downturn, said Jay Mueller, a portfolio manager at Wells Capital Management in Menomonee Falls, Wisconsin.

“The commercial real estate problem is not over by a long shot," says Karen Finerman. It’s the kind of unwind that happens in slow motion.”

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